Corporate Finance: Solved Problems

Capital Budgeting Decisions

One core area is capital budgeting. Imagine a company considering a new factory. To decide if it’s worthwhile, we use techniques like Net Present Value (NPV) and Internal Rate of Return (IRR). Let’s say the factory costs $1 million upfront and is projected to generate $300,000 in cash flow for five years. If the company’s cost of capital (discount rate) is 10%, we calculate the present value of each year’s cash flow and sum them. If the NPV (sum of present values minus initial investment) is positive, the project is accepted. If the IRR, the discount rate that makes NPV zero, exceeds the cost of capital, it’s also a good sign. A negative NPV or an IRR lower than 10% suggests the investment isn’t profitable at that cost of capital.

Working Capital Management

Another crucial area is managing working capital. Consider a retailer needing to optimize inventory. They might use the Economic Order Quantity (EOQ) model. Suppose annual demand is 10,000 units, ordering cost is $50 per order, and holding cost is $5 per unit per year. The EOQ formula (√(2DS/H), where D=Demand, S=Ordering Cost, H=Holding Cost) gives us an optimal order quantity of √(2*10000*50/5) = 447 units approximately. This minimizes the total inventory costs (ordering + holding). Effective working capital management directly impacts a company’s liquidity and profitability.

Capital Structure and Financing

Determining the optimal capital structure (mix of debt and equity) is critical. A company might analyze the impact of different debt levels on its Weighted Average Cost of Capital (WACC). If the company issues more debt, the cost of debt might be lower than the cost of equity, initially lowering WACC. However, excessive debt increases financial risk, potentially raising the cost of both debt and equity, and ultimately increasing WACC. Finding the debt-equity ratio that minimizes WACC maximizes the company’s value. Models like the Modigliani-Miller theorem (with and without taxes) provide a theoretical framework, although real-world complexities require careful analysis of factors like bankruptcy costs and agency costs.

Valuation

Valuation is essential for making investment and acquisition decisions. A common method is Discounted Cash Flow (DCF) analysis. For instance, valuing a company requires projecting its future free cash flows (FCF) and discounting them back to the present using the WACC. If a company is projected to generate $1 million in FCF next year, growing at 3% annually, and the WACC is 8%, the present value of the company can be calculated using the Gordon Growth Model (FCF1 / (WACC – Growth Rate)). In this case, $1,000,000 / (0.08 – 0.03) = $20 million. The valuation heavily relies on the accuracy of projections and the appropriateness of the discount rate.

Dividend Policy

Finally, dividend policy decisions affect shareholder value. A company with ample cash flow needs to decide how much to pay out as dividends versus reinvesting in growth. A stable dividend policy might signal stability and attract income-seeking investors. However, high-growth companies might prefer retaining earnings for further expansion, leading to a lower dividend payout ratio. The optimal dividend policy balances shareholder preferences and the company’s long-term investment opportunities.